ANALYSIS OF RIGHT TO SUBROGATION UNDER IBC REGIME

A guarantee is required in practically every business transaction since the parties want to be sure that the debtor will be able to satisfy his obligations, or we can say that it is quite normal for the lender to request security before releasing the funds to the borrower. The practice of guarantee is essential to the functioning of a substantial portion of the credit market. In the business world, this is often accomplished by subscribing to the borrower’s quasi-debt securities or obtaining a guarantee from the debtor’s proprietors or group firms. In a loan transaction between P and Q, for example, C operates as a guarantee, ensuring that if P, a corporate debtor, fails to fulfil its commitments, the guarantor would be held responsible. A guarantee is a legitimate contractual agreement among three parties, and its parameters have indeed been constructed to meet the parties’ demands. Certain provisions, however, have been enshrined in the Indian Contract Act of 1872, which protects the rights of both guarantor and creditor.

A promise to do something or to refrain from doing something is sufficient for a guarantee to be considered. Furthermore, the surety/guarantor is subrogated to the rights of creditors that have to be fulfilled by the debtor or the borrower, i.e., the surety assumes the role of the creditor and can be able to enforce all of the creditor’s securities against the borrower on whose behalf the payment is made[1]. The concern about whether a guarantor’s right to subrogation is protected or not in accordance with the IBC regime originated in a variety of landmark decisions, including the Essar Steel case and the Lalit Mishra case. However, no specific clarification of the right to subrogation has been provided. In certain situations, it has been said that granting the guarantor the right to subrogation will have a negative influence on the I & B Code’s core objective, whilst in others, it has been stated that the right to subrogation is a natural right and should be provided to the guarantor. So, in this article, we will look at the position of the right to subrogation under IBC and how it affects the market as well as the corporate debtor.

Introduction

Before delving into the benefits and drawbacks, some clarification is in order regarding what constitutes a right to subrogation and what the basic requirements are for becoming a guarantor. The court in the case of Morgan v. Seymore[2] ruled that if the guarantor has executed the honoured obligations and repaid the debt or dues, then it’s allowed that the surety can assume in the place of the creditors and have the same rights against the principal debtor as the creditor. Section 128[3] of the Indian Contract Act of 1872 provides for the debtors and the guarantors joint and several liabilities unless provided in the contract act. In this, the liabilities of both debtor and guarantor are joint and several and the creditor can ask for debt from any of the debtor or the guarantor or from both simultaneously.

This means that the lender is not obligated to exhaust its remedies against the borrower before proceeding against the guarantor, assuming no such express terms exist in the contract. Section 140 states that “Where a guaranteed debt has become due or default of the principal debtor to perform a guaranteed duty has taken place, the surety upon payment or performance of all that he is liable for, is invested with all the rights which the creditor has against the principal debtor”[4].  It means subrogation occurs when the surety assumes the role of the creditor after payment of the sum owed to the creditor. This right of subrogation is founded on the equitable principle that the guarantor should be indemnified.[5] However, once the guarantor has fulfilled its obligations to the corporate debtor’s creditors, the guarantor loses the power to sue the corporate debtor under the IBC.  So, we’re here to talk about the situation of a guarantor under the IBC in terms of entitlement to subrogation, as well as the benefits and drawbacks of doing so.

Right to subrogation under IBC

The surety who pays off the debt takes the creditor’s position and has all of the creditor’s obligations in order to pursue reimbursement. The court in the matter of Amrit Lalan Goverdhan v. State Bank of Travancore[6] stated that it is the most basic concept of natural justice. So, the surety/guarantor is subrogated to all in terms of the creditor’s responsibilities against the principal debtor, which means that the guarantor assumes the creditor’s position and is entitled to enforce all of the creditor’s collateral against the borrower on whose behalf the payment is made. In addition, the court ruled in State of Madhya Pradesh v. Kaluram[7], that the surety has a claim to the creditor’s rights against the principal debtor deriving from the transaction that gives birth to the right or obligation upon payment of the debt or execution of everything for which he is responsible. As a result, upon payment of the sum owed by the major debtor, the surety is entitled to be placed in relation to the principal debtor; they are in the same position as the creditor.

Moving on, if a corporate borrower is not obligated to pay the guarantee, the party is considered to be unjustly enriched if his financial condition is considerably improved or the financial burden is lifted. If, in fact, the guarantor’s money was used to affect the improvement, the enrichment would be at the expense of the guarantor. If the surety honours its obligations to the creditor, the principal borrower is free from all liabilities against the creditor; however, if the guarantor is not granted the right to subrogation, the principal borrower is unfairly enriched at the expense of the guarantor’s money because the amount paid to the creditor is the guarantor’s amount, whereas the surety has an equitable right to be subrogated. However, once the corporate debtor’s creditors have been reimbursed by the guarantor, the IBC regime makes no provision for the right to subrogation therefore the guarantor does not have the right to proceed against the corporate debtor under the IBC. The right of subrogation is the foundation of the guarantee concept, which is an essential component of any commercial transaction. Therefore, it is imperative to analyze the impact of such denial of the right of subrogation under IBC[8].

The flip side effect on the market must be watched.  If the guarantors are not provided recovery rights, they will be unwilling to stand as guarantors in any transaction, which will have a significant impact on the credit market, on which every transaction is substantially dependent. In addition, not granting the right to subrogation violates Section 30(2)(e)[9], because the plan without the right to subrogation violates the Indian Contract Act of 1872, which is currently in effect.

However, the right to subrogation has been denied to the guarantors in the IBC regime. It was first attempted in the Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors.[10]. The reasoning is that recognizing the power of subrogation would result in guarantors bringing claims against the resolution applicant, defeating his entire purpose of stepping forward to buy and revive the company because he would have to pay the same amount that was due. The goal of CIRP is to maximize the asset value of the firm and to bring it back from the brink of bankruptcy by balancing the interests of all creditors and restoring the company’s viability. Giving the guarantors the power to reimburse the amount from the corporate debtor’s assets will restart the cycle of non-payment, default, and recovery, putting stress on the company’s assets and contradicting the CIRP’s purpose. However, the NCLT also ruled that the guarantor cannot utilize its right of subrogation under the Contract Act since IBC actions are not recovery proceedings. Section 238 of the IBC Code, 2016, is commonly known as the “non-obstante provision “which provides that the Code shall have an overriding effect over all other laws which are inconsistent with the Code. The same reasoning was used in the Essar Steel India Ltd. Committee of Creditors v. Satish Kumar Gupta[11], where the claimant sought reimbursement from the resolution applicant by exercising his right to subrogation after honouring its obligations to creditors, but the Supreme Court denied the claim, stating that the guarantor is not discharged of its liability even after approval of a resolution plan.

Conclusion

After a thorough reading of this piece, we see that the stand of a guarantor in the IBC regime is still not clear. If the right to subrogation is provided, it may have strange consequences because the resolution applicant is obligated to pay the guarantor, which is contrary to the IBC’s goal of reviving the company by maximizing the value of its assets, and this was not the intention of Parliament when it enacted this statute. And if the right to subrogation is not provided to the guarantor then it may violate the principle of natural justice because it is an equitable right to be subrogated. The cases on the use of equitable subrogation to prevent or reverse unjust enrichment are all cases of defective transactions.[12] As a result, the law is still growing, and it is hoped that these difficulties will be resolved in due time.

Author(s) Name: Jyoti Dahiya (National Law University and Judicial Academy, Assam)

References:

[1] Amrit Lal Goverdhan Lalan v. State Bank of Travancore, AIR 1968 SC 1432.

[2] Morgan v. Seymore, (1638) 1 Rep Ch 120

[3] Indian Contract Act, 1872, s 128

[4] Indian Contract Act, 1872, s 140

[5] Duncan Fox & Co. v. North and South Wales Bank, (1980) 6 AC 1.

[6] Supra Note 1.

[7] State of Madhya Pradesh v. Kaluram, (1967 (1) SCR 266 AIR 1967 SC 1105) 

[8] Gopal Guar, The CBCL Blog. 2022. Right of Subrogation under IBC: Impact on Market – The CBCL Blog, available at: <https://cbcl.nliu.ac.in/banking-law/right-of-subrogation-under-ibc-impact-on-market/> [Accessed 13 August 2020].

[9] The Insolvency and Bankruptcy Code, 2016, s 30(2)(e)

[10] Lalit Mishra & Ors. v. Sharon Bio Medicine Ltd. & Ors., 2018 SCC OnLine NCLAT 669

[11]Essar Steel India Ltd. Committee of Creditors v. Satish Kumar Gupta, (2020) 8 SCC 531; 2019 SCC OnLine SC 1478

[12] Swynson Ltd. v. Lowick Rose LLP (formerly Hurst Morrison Thomson llp) (in liquidation), [2017] UKSC 32.

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